John Hussman: It Is Informed Optimism To Wait For The Rain

Based on valuation metrics that have demonstrated a near-90% correlation with subsequent 10-year S&P 500 total returns, not only historically but also in recent decades, we estimate that U.S. equities are more than 100% above the level that would be associated with historically normal future returns. We presently estimate 10-year nominal total returns for the S&P 500 averaging just 2.2% annually over the coming decade, with zero or negative nominal total returns on every horizon of less than 7 years. Regardless of very short-term market direction, it is urgent for investors to understand where the equity markets are positioned in the context of the full cycle.

Importantly, this expectation fully embeds projected nominal GDP growth averaging over 6% annually over the coming decade. To the extent that nominal economic growth persistently falls short of that level, we would expect U.S. stock market returns to fall short of 2.2% nominal total returns (including dividends) over this period. These are not welcome views, but they are evidence-based, and the associated metrics have dramatically higher historical correlation with actual subsequent returns than a variety of alternative approaches such as the “Fed Model” or various “equity risk premium” models. We implore investors (as well as FOMC officials) to examine and compare these historical relationships. It is not difficult – only uncomfortable.

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Objectively, there is no specific level at which investors can be told “no, stop, don’t” once the speculative bit is in their teeth. Historically, however, such periods have typically reached their extremes when a syndrome of overvalued, overbought, overbullish, rising-yield conditions emerges. By the time one observes extreme conditions simultaneously – rich valuations, overbought market conditions, lopsided bullish sentiment, and rising 10-year yields – equity markets have generally been at precarious and climactic highs. Prior to the current market cycle, these points singularly include 1929, 1972, 1987, 2000, and 2007 (slightly broader criteria also would include 1937). In the uncompleted half-cycle since 2009, however, we’ve seen these conditions at the 2011 market peak (followed by a near 20% decline that was truncated by investor enthusiasm about fresh quantitative easing), and several instances over the past year – specifically, February 2013, May 2013, December 2013, and today.

Investors and policy-makers that focus attention on some alternative valuation measure (usually because it seems pleasantly benign) would be well-advised to examine the data, and compare the historical relationship between competing measures and actual subsequent market returns. Remember also that outliers are instructive. For example, the actual total return on equities in the decade following 1964 was much weaker than one would have projected, because stock valuations collapsed at the 1974 market low. Conversely, the actual total return on equities in the decade following 1990 was much stronger than valuations would have projected, because valuations became so extreme by the 2000 bubble peak. To the extent that stocks have done a few percent better in the most recent 10-year period than valuations would have projected, it is because stocks have become so profoundly elevated at present. Such outliers are the first thing to be wiped out over the completion of the market cycle.

Again, regardless of very short-term market direction, it is urgent for investors to understand where the equity markets are positioned in the context of the full market cycle. While the most extreme overvalued, overbought, overbullish, rising-yield syndrome we define has generally appeared only at the most wicked market peaks in history, investors have ignored those conditions over the past year. We can’t be certain when the deferred consequences will emerge. But a century of market history provides strong reason to believe that any intervening gains will be wiped out in spades.

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A final note – in my view, it is incorrect to believe that the 2008-2009 market plunge and financial crisis were caused by the housing bubble. The housing bubble was merely the expression of a very specific underlying dynamic. The true cause of that episode can be found earlier, in Federal Reserve policies that suppressed short-term interest rates following the 2000-2002 recession, and provoked a multi-year speculative “reach for yield” into mortgage securities. Wall Street was quite happy to supply the desired “product” to investors who – observing that the housing market had never experienced major losses – misinvested trillions of dollars of savings, chasing mortgage securities and financing a speculative bubble. Of course, the only way to generate enough “product” was to make mortgage loans of progressively lower quality to anyone with a pulse. To believe that the housing bubble caused the crash was is to ignore its origin in Federal Reserve policies that forced investors to reach for yield.